International Funds Combat High-Fee Prejudices

Despite extended periods of disappointing returns and the stigma of significantly higher expenses than their State-side counterparts, foreign equity and emerging market funds are not without hope when it comes to luring new investors. And one of the ways they are gaining favor is by steadfastly laboring to lower fees.

International funds represent a significant niche in the market, with about $158 billion in total net assets. As a category, expenses average 1.72%, according to Lipper. And returns have not been all that great, either, with the category down -4.9% year-to-date, down -20.5% in the trailing year and off -6.7% in the previous five years.

Emerging market funds face even steeper hurdles, as the average expense ratio is a gaudy 2.14%. Total net assets are also significantly less at $28.8 billion and year-to-date returns are off -2%. They are down -17.6% in the last year and suffered a decline of -5.8% in the last five-year period.

Martin Schulz, director of international equity investments for National City Investment Management Co., advisor to the Armada Funds, said that the higher costs often come from greater expenses incurred by the fund companies when completing very basic portfolio-management tasks, such as executing trades.

30 Cents vs. Five Cents

Trading in foreign markets can often cost around 30 cents per share versus five to six cents a share for domestic equities, he said. Additionally, complexes must commit large chunks of money to local governments just to trade in certain locations like India, Taiwan, or Korea. Schulz also said custodial fees tend to drive costs up.

As Schulz' firm aims to visit 80% of the firms they own, travel expenses can add up. Bill Rocco, a senior analyst with Morningstar of Chicago said research and training are both more difficult and therefore more costly. More staff is generally required as well. U.S.-based funds, which tend to be larger, are able to keep lower ratios in part because costs are spread out over a larger asset pool.

A little fine-tuning with a tweak here and there and Schulz said his firm was able to bring expense ratios down. The Armada International Equity Fund expense ratio went from 1.45% in 2001 to 1.34% in 2002. Despite having less leeway and more cost-controls in place, Schulz said the one thing he and his team have focused on is becoming more tax efficient. He said the fund has decreased turnover and allows its traders to place orders electronically instead of with brokers.

Like most of the rest of the market, the Armada International Equity fund has been in negative territory in the past three years, lagging behind its benchmark by -4.2 percentage points in that time frame. But the fund is only off -6% year-to-date and is ahead of its peers by 0.5%.

Additionally, he said the fund has about 25% of their portfolio in ADRs, which saves them 25% differential in trading costs and frees the fund from custody charges. Schulz also invests in foreign index futures, which carry very low trading costs.

A Lot to Contend With

Combating uncertainty is one thing, but fighting apathy is a whole other animal. Those offering emerging markets and foreign equity funds face both beasts. There are geopolitical concerns, military conflicts, economic developments in hosting nations and even environmental or regional concerns. Rocco mentions the outbreak of Severe Acute Respiratory Syndrome, or SARS, outbreak in Asia as the type of phenomenon that can cause investors to pull back.

Securities of foreign companies and their markets may be less liquid and much more volatile, and many emerging markets are relatively small and the trade volume is concentrated on a smaller number of industries.

More than anything, one of the largest obstacles for emerging market funds is the apathy of the American investor. One-half of the world's stock market is outside of the country, yet only a mere 15% of U.S. equity assets are invested in funds outside our borders.

The old proverb not to judge a book by its cover is particularly fitting, as a number of international and emerging market funds have bucked their stereotype and have very cheap expense ratios. While domestic fund expenses generally hover around 1.3% to 1.4%, select international funds can feature ratios of less than one-half of one percent.

A number of the low-expense international funds are index funds, such as the Fidelity Spartan International Index and the Vanguard Total International Stock Index. They allow investors to get the broad exposure to the world they so desire without high expenses.

Despite hurdles, there is an opportunity for fund complexes to catch the bigger fish in the investing pool. Many larger investors looking for extra pop in their portfolio may turn to foreign markets, and the companies that have the best managers will be the winners. Many will be willing to overlook higher fees as long as they are making a profit.

"Let a good manager get you access to companies that are headquartered outside of our borders," Rocco said. "There's a lot of great companies, and why not pick a great manager who can buy them for you?"